A:

Shareholders' equity is often thought of as another piece of confusing stock market terminology. In reality, shareholder equity is a key concept in corporate accounting and an important measure of company valuation. Despite its lofty purpose, the calculation of shareholder equity is simple. Shareholders' equity is a company's total assets, minus its total liabilities.

So what does a large amount of shareholder equity signify about the financial health of a company? Firstly, it indicates the company is on solid financial ground. Shareholder equity represents owned funds that can be used to pay dividends to investors or to stimulate additional growth. These goals can also be funded by taking on debt, such as bank loans, though borrowing money is inherently riskier. A high level of shareholder equity means growth or dividends can be funded without the risk of bankruptcy in the event of a business downturn. For companies that primarily use debt financing, a dip in sales can mean big trouble since payments on liabilities must be made regardless of revenue fluctuation.

However, not all debt is bad debt, and a high level of shareholder equity can also mean a company is not optimally leveraged. Companies use debt, or leverage, as a means to expand operations at a rate that is not possible using shareholder equity alone. Especially for businesses in their early years, using debt to stimulate rapid growth can be a lucrative business strategy. An expanded business can mean greater profits for the business owners and their shareholders. So while a large amount of shareholder equity is a sign of financial strength, an unusually high ratio of equity to debt can signify a company is missing out on the potential growth opportunities offered by leverage financing.

RELATED FAQS
  1. What is the difference between a company's equity and its shareholders' equity?

    Understand the difference and the interrelationship between shareholders' equity in a company and the company's actual total ... Read Answer >>
  2. How do you calculate shareholders' equity?

    A company's shareholders' equity is calculated by subtracting a company's total liabilities from its total assets, and can ... Read Answer >>
  3. What is the most widely used gearing ratio?

    Understand the most commonly used gearing, or leverage, ratio used to evaluate a company's financial condition, the debt ... Read Answer >>
  4. Which financial ratio best reflects capital structure?

    Learn about the debt-to-equity ratio and why this metric is widely considered the most useful reflection of a company's capital ... Read Answer >>
  5. What role do shareholders play in a capital budget?

    Learn about why shareholders play an integral role in capital budgeting and how it benefits businesses to use equity capital ... Read Answer >>
  6. Which is more important when estimating cost of capital - debt or equity?

    Learn about the relative costs of debt and equity and how they affect the overall cost of capital, including why debt may ... Read Answer >>
Related Articles
  1. Investing

    What is the Shareholder Equity Ratio?

    The shareholder equity ratio shows how much money shareholders will receive if a company has to liquidate its assets.
  2. Investing

    What Does Negative Shareholder Equity On A Balance Sheet Mean?

    Negative shareholder equity on a company’s balance sheet is a red flag that should prompt potential investors to take a closer look before committing their money.
  3. Managing Wealth

    Knowing Your Rights As A Shareholder

    We delve into common stock owners' privileges and how to be vigilant in monitoring a company.
  4. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    Analysts use specific leverage ratios to compare firms within an industry. A basic understanding of these ratios helps when evaluating oil and gas stocks.
  5. Investing

    5 Tips For Reading A Balance Sheet

    If you know how to read it, the balance sheet provides valuable information on a potential investment.
  6. Investing

    Balance Sheet: Analyzing Owners' Equity

    Analyzing owners’ equity is an important analytics tool, but it should be done in the context of other tools such as analyzing the assets and liabilities on the balance sheet.
  7. Investing

    Reinvesting Capital Gains In Leveraged Portfolios

    Don't get forced into action. Learn how to plan properly to avoid making rash decisions.
  8. Investing

    What are Preference Shares?

    Preference shares, also referred to as preferred shares, are equity shares that give the shareholders certain rights ahead of common shareholders. For instance, when the corporation declares ...
RELATED TERMS
  1. Shareholders' Equity

    A firm's total assets minus its total liabilities. Equivalently, ...
  2. Shareholder Equity Ratio

    A ratio used to help determine how much shareholders would receive ...
  3. Shareholder Value Transfer - SVT

    A metric intended to guide shareholders in how much equity compensation ...
  4. Return On Equity - ROE

    The amount of net income returned as a percentage of shareholders ...
  5. Equity Multiplier

    The ratio of a company’s total assets to its stockholder’s equity. ...
  6. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding ...
Hot Definitions
  1. Covariance

    A measure of the degree to which returns on two risky assets move in tandem. A positive covariance means that asset returns ...
  2. Liquid Asset

    An asset that can be converted into cash quickly and with minimal impact to the price received. Liquid assets are generally ...
  3. Nostro Account

    A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts ...
  4. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  5. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  6. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
Trading Center